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Sunday, November 2, 2008

The Warren Buffett Way: Chp3 Part 2: Mr. Market and the Lemmings

EconomicsWarren doesn't put any effort into market timing or into judging economic cycles. He does however, spend a fair bit of time thinking about inflation and how it could affect a company's business. Buffett has studied the historical returns on U.S. equities and has noted that the returns were quite stable over the time period he investigated. Importantly, the returns on equity showed no correlation with the rise or decline of inflation.

Operating margins is one of the factors affecting the return on equity ratio. Many managers believe that operating margins can be increased during high inflationary periods. However costs are also rising during inflationary periods and the overall effect on margins is not certain. Buffett points out that a comparison of Federal Trade Commission reports of manufacturing companies from the 1960's and 1970's, shows that despite rising inflation, those companies in aggregate had declining operating margins!

In general, companies with a high ratio of fixed assets to sales earn low rates of return on capital. Those companies have to significantly reinvest in capital equipment to maintain the status quo. The capital reinvestment for those companies often comes at the expense of not being able to pay dividends or buy back company shares.

Buffett seeks out companies that require little in the way of fixed assets because they are less exposed to the negative effects of inflation. In particular, he looks for companies that have significant amounts of economic goodwill. Economic goodwill refers to the ability of a company to charge premium prices and earn high returns on capital. The value of economic goodwill also rises with inflation.

Buffett has observed that during inflationary periods, the companies that fare well are those that combine economic goodwill with modest increases of capital investment. Those companies, due to their higher profit margins and low capital requirements, are able to pay out and increase dividends and repurchase company shares.

LemmingsBuffett laments that despite the number of well educated people on Wall Street, that there is not a more logical and rational force operating in the financial markets. Buffett notes that the "lemming-like" behaviour of institutional investors has a lot to do with the wild volatility seen in public stock prices.